Feeding the hand that bites you …

Justin Lahart writes well; I stole the "feeding the hand that bites you" line from him. It is a good one.

The US tells China (oops, CNOOC) that it cannot buy Unocal, even though Unocal's energy assets were primarily in Asia and Chinese firms have far fewer overseas assets than American firms. China responds by ... purchasing just as much US debt as before.

In January, China increased its Treasury holdings by $5.9 billion or so, its holdings of Agencies by $3.4b, and its holdings US corporate bonds by $2.7b - for a total of nearly $12b. Feeding the hand that bites you.

The US criticizes China's exchange rate regime. China gets annoyed that another country wants to tell it what to do with its exchange rate regime. But private investors start to think that China just might let the RMB move a bit faster, so money starts to flow into China. China has to intervene more heavily in the market, buys more dollars, and ultimately, buys more Treasury bonds. Feeding the hand that bites you.

We don't yet know how many dollars China bought in January, but judging from the TIC data, it was not a small sum. The US needs about $80b a month to finance its current account deficit ($70b for its trade deficit). That can come from the world's banks, from foreign direct investment (in excess of US investment abroad) or from the sale of long-term debt and US equities. Recently, it has come from the sale of long-term debt.

So who is doing the buying? China for sure. Brazil too. They bought dollars in January to offset all the foreign hot money chasing yield in Brazil.

But also Dubai's sheik. Abu Dhabi's investment authority (Abu Dhabi is another of the emirates). Kuwait's investment authority. And the central banks of Russia and Saudi Arabia. OPEC increased its Treasury holdings by $11 billion in January.

Folks with oil have tremendous sums to play with right now. Think roughly $400b a year. Split between central banks, investment funds and the private accounts of various sheiks, princes and oligarchs.

As Justin Lahart notes, the big money in the Gulf isn't terribly happy that the US isn't willing to let Dubai Ports World operate US ports.

The Emirates is talking of shifting $2 b in reserves into euros.

They don't want to keep on feeding the hand that just bit them.

But I suspect, like the Chinese, they will find it is hard not to.

Suppose they start buying up the (dollar-denominated) bonds of emerging economies, whether an emerging economy like Turkey with a current account deficit or one like Brazil with a surplus. What then happens? Well, Brazil and Turkey have more dollars - and both already are pulling in more funds that they need. Both are already building up their reserves.

So what ultimately happens? The Gulf countries still end up with assets denominated in dollars (and thus are stuck with the risk that the dollar will fall). And Turkey and Brazil have to invest the dollars that they have raised by selling dollar debt somewhere ... The Gulf sheiks are still feeding the hand that just bit them, only indirectly.

That is some sense is the story hidden in the January TIC data. Private investors dumped money into emerging markets. Emerging markets built up their reserves by something like $60b in January. They bought $20b in long-term US debt. Probably more actually. And they build up their short-term claims on the US too ... central bank holdings of short-term treasuries rose by $8.5 b. That is a lot of financing from the world's central banks.

Suppose oil sheiks start shifting into euros, big time. Forget $2b of the Emirates $23b in reserves. $2b is chump change; it is two days worth of the oil states combined oil windfall. Saudi Arabia and Russia each add over $5b to their reserves (including all SAMA assets) each month. A real shift would imply that the oil states, who are now buying maybe $10b a month in euros, would need to start buying $20b a month in euros. Remember that the oil states now have roughly $35b a month, maybe more, that they have to invest somewhere ...

What happens if the oil states start buying euros? The euro probably rises against the dollar. A $120b swing is big, even in today's global economy. The Gulf states all peg to the dollar. So their currencies fall. And their citizens external purchasing power falls. The value of their existing stock of dollars falls (tough luck; what do you expect financing a country with a $950 b current account deficit?). And since their currencies fall, they will import less. Gucci ain't cheap, even with the euro/ $ at 1.20. And save more. And have even more funds to invest.

How can these countries stop financing the hand that bites them?

Spend more and save less, so they have fewer funds to invest abroad.

And stop pegging to the dollar.

But for now, they don't want to change their currency regimes. China clings tenaciously to its (outdated) plan for a super-slow transition to more flexibility. The Gulf states don't even want to talk about the (even more outdated) dollar pegs.

And so they are all, in effect, opting to keep on feeding that hand that bites them.

And if they are smart, they should realize that buying dollars and dollar bonds doesn't mean that they can trade their dollars for US companies. At least not on a scale that it is at all comparable to the amount of financing that they provided the US.

I would bet - if you include bonds bought indirectly through London - that emerging markets bought about ½, or $500b, of the long-term debt that the US sold abroad in 2005. I would bet that emerging markets accounted for about $20b of the $120b or so of foreign direct investment in the US. And maybe $20 b of the $80b or so in portfolio equity sold abroad

That is a pretty unusual ratio. $500b in debt; $40b in equities. I understand why China and the oil exporters might want more equity and a bit less debt.

But I also suspect the US is far more willing to sell $500b in debt to China's central bank and the oil sheiks central banks than to sell $500b in US equities to Chinese state-owned firms and the oil sheik's "private" firms. That's life. Lectures on the virtues of cross-border takeovers from London investment bankers eager for their cut, Tom "Dubai not Iraq is the now the model" Friedman, the FT, US economists (even Nouriel Roubini and Brad DeLong) and the Bush Administration won't change that reality.

At least that is my best political judgment.

The US right now suffers from a bit of cognitive dissonance.

I suspect Americans have assumed that open capital markets meant that US firms would be able to profit from investing abroad (and maybe the US could profit from exporting its "dark matter" to the rest of world). Yet that isn't a full description of the world we live in. The US doesn't save enough to finance investment in the US, let alone to finance investment abroad.

Yet the US still thinks of itself as, if not a creditor, at least an intermediary. Not as a big net borrower that desperately needs financing from abroad.

One example: Even though I know next to nothing about investing in ChinaI am occasionally invited to talk about investment opportunities in China for US investors. These conferences are about opportunities for US investors, they assume that China needs financing from the US. The macroeconomic reality, as we know, is rather different: right now China finances the US. Yet I am never invited to talk about the opportunities created by Chinese demand for US assets.

The US doesn't think of itself as debtor in part because the United States' creditors have been so kind. Financing the US in dollars at low rates. Taking debt and not asking for any equity. And so on.

And since the United States creditors have been so kind, the U.S. hasn't felt pressure to be kind to them.

The only real question is whether those countries now financing the US are willing to change the policies that led them to buy $500b in debt from the US in 2005. Otherwise, they had better get used to feeding the hand that bites them.